This is the twentieth in a weekly series of articles providing a chapter-by-chapter in-depth “book club” reading of Benjamin Graham’s investing classic The Intelligent Investor. Warren Buffett describes this book: “I read the first edition of this book early in 1950, when I was nineteen. I thought then that it was by far the best book about investing ever written. I still think it is.” I’m reading from the 2003 HarperBusiness Essentials paperback edition. This entry covers the nineteenth chapter, which is on pages 487 to 496, and the Jason Zweig commentary, on pages 497 to 511.

There’s an eight hundred pound gorilla in the room when it comes to value investing: the corrupt company.

When you go through a filtered list of companies that might represent great value investments, many of those companies actually are values. They’re simply boring companies – ones that are well established, grow slowly, and dominate a niche that doesn’t get people excited.

At the same time, that list is going to contain at least a few companies that got there because of shady business practices. The company appears to be worth a lot on paper, but in truth it’s all a house of cards. It’s only an illusion of a value, not a real value.

Some of these are easy to detect. Companies like Enron wind up, years after their corruption is exposed, appearing to be a value stock, but a careful evaluation of the history of the company shows it to be a bad investment. Other companies, though, are much more difficult to see – mismanagement isn’t always immediately clear in the hottest companies, let alone the ones that lurk in the quieter parts of the market.

Chapter 19 – Shareholders and Managements: Dividend Policy
Here, Graham seems to indicate that if a stock that otherwise appears to be a value stock isn’t paying out dividends, something is afoot. If there’s not a very clear and concrete reason for no dividends (and the overly simplistic “we’re investing in the company” isn’t satisfactory), then there’s something afoot.

This is not true for companies that would be considered “growth” investments. Quite often, the absence of a dividend (or the presence of only a small dividend) in a growth company is a sign that the company is actually doing what they claim – investing in the company with the intent of maintaining the impressive rate of growth.

The big difference is in why you invest in these different types of stocks. You invest in growth stocks to enjoy the increase in stock price – dividends aren’t really a part of the equation. You intend to ride that wave of growth until it runs out, then sell the stock somewhere near the peak (when the stock is still selling at a premium because of its “growth” status, but the growth is slowing).

However, the typical reason for owning a value stock is income. You don’t expect that the price of a value stock will jump greatly over time. Instead, you own it for that dividend – it’ll keep putting money in your pocket over the long haul. This isn’t a good enough reason for speculators to own the stock – dividend earnings are a long term thing – so good value stocks tend to be forgotten in the mad rush.

If you see a stock that’s undervalued, it should either be paying out a good dividend, have a stellar reason for not doing so, or it should be avoided.

Research by money managers Robert Arnott and Clifford Asness found that when current dividends are low, future corporate earnings also turn out to be low. And when current dividends are high, so are future earnings. Over 10-year periods, the average rate of earnings growth was 3.9 points greater when dividends were high than when they were low.

What does that mean? Good, strong companies can afford to pay out dividends. Thus, to an extent, a company paying solid dividends – particularly over a lot of years – is likely a company that’s on very solid footing and sure of their future.

Companies that pay good dividends don’t need to hoard money. They don’t need to invest in themselves. Instead, they’re able to provide direct value to their stockholders.

It’s a pretty good argument for value stocks, I must say.

Next Friday, we’ll take a look at the final chapter, Chapter 20: “Margin of Safety” as the Central Concept of Investment.

Company

Our Brands

Advertising Disclosure: TheSimpleDollar.com has an advertising relationship with some of the offers included on this page. However, the rankings and listings of our reviews, tools and all other content are based on objective analysis. The Simple Dollar does not include all card/financial services companies or all card/financial services offers available in the marketplace. For more information and a complete list of our advertising partners, please check out our full Advertising Disclosure. TheSimpleDollar.com strives to keep its information accurate and up to date. The information in our reviews could be different from what you find when visiting a financial institution, service provider or a specific product's website. All products are presented without warranty.